DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
LEASE-PURCHASES IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Lease-purchases have always been a favorite tool of residential real estate investors. They are one of the "Big Three" – alongside contracts for deed and lease-options – all of which are creative devices for getting less than fully-qualified buyers into a home. These contracts have been traditionally popular in Texas for two reasons: first, it was easy to get tenant/buyers into the home by offering a low down payment; and second, it was easy for sellers to evict them through the forcible detainer process if they defaulted (and still keep the down payment).
In a typical lease-purchase (or "rent to own"), a portion of each monthly rent payment is (allegedly) set aside and credited toward the tenant/buyer´s down payment. It is common (but not universal) for a lease-purchase to provide that after a certain amount is paid in, the tenant is able either (1) to convert the transaction from a lease to an owner-financed sales transaction in which the tenant gets a warranty deed and gives back a note and deed of trust to the seller; or (2) the seller agrees that the tenant/buyer may show the accumulated down payment on a loan application to a third-party lender and thereby qualify for "take out" financing.
Lease-purchases, lease-options, and contracts for deed present serious burdens and risks to sellers under Texas Property Code 5.061 et seq. relating to "executory contracts" – i.e., contracts that remain essentially unfinished for a period of longer than 180 days. Sec. 5.061 provides that numerous initial and ongoing requirements must be observed if an executory contract is going to be properly implemented, and the burden (as well as all the risk of violation) is entirely on the seller to meet these. More on these requirement and penalties below.
The Dark History of Executory Contracts
In the past, unscrupulous sellers abused executory contracts by disregarding the buyer´s equitable rights and misrepresenting to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases (which was manifestly untrue). Sellers were then able to obtain evictions for minor or technical defaults, often confiscating large down payments in the process. The seller was then free to move on to his next "victim" and obtain another down payment. The legislature rightly acted to stop such abuse.
What exactly is an "Executory Contract"
An executory contract is any transaction that defers some action by either party that pertains to ownership or possession of real property into the future. Think of it this way: an "executed" contract is one that is fully performed today. It is done, finished. An "executory" contract, on the other hand, leaves something dangling. Usually the dangling item is the most important item of all, namely, who owns title to the property while the contract is pending and when does the buyer get the deed?
A seller improperly engaging in an executory contract incurs not only penalties under the Property Code (e.g., the return by the seller of all payments made by the buyer, including the down payment and monthly payments) but also liability under the Deceptive Trade Practices – Consumer Protection Act ("DTPA"), which can involve treble damages plus attorney´s fees. Even in minor transactions, small numbers can turn into big ones as a result. Note that the Property Code includes no seller defenses – even if the whole arrangement was the buyer´s idea in the first place.
Because of the burdensome requirements and penalties of Prop. Code Sec. 5.061, a landlord/seller may be tempted to re-write a traditional lease-purchase in an attempt to call it something else or make it appear as if it is something else. The important point to remember is this: if it´s an "executory contract," then Sec. 5.061 applies – regardless of the title or wording of the document. Judges tend to look to substance over form (the "if it quacks like a duck" theory).
A complication that occurs with many lease-purchases (aside from the obvious fact that they are executory contracts) is that they may provide that once a sufficient down payment is paid in the tenant/buyer will have an option to purchase the property at a certain price. Result? The lease-purchase has become tangled up with a lease-option – and becomes become a hybrid "lease-purchase-option."
What if the lease-purchase provides that payments will continue over a number of years until the property is paid for? Then it may not be a lease-purchase at all. It may more properly be described as a contract for deed.
Two points are worth noting. The first is that each of these devices – lease-purchases, lease-options, and contracts for deed – can, if only slightly modified, become hybridized with something else, sinking the transaction deeper into the executory contract hole. The second point is that regardless of the ultimate form such hybrid contracts take, they remain executory contracts for purposes of the rules and penalties of Prop. Code Sec. 5.061 et seq.
The Six-Month Lease-Purchase-Option ("Stacking")
Lease-purchases may theoretically be used if the term is 180 days or less, although this is such a short period of time most buyers will not be able to accumulate much of a down payment. So what about the possibility of "stacking" contracts for a short period – say, 179 days to be safe – allowing the lease-purchase to expire but providing that it then automatically renews for an additional 179 day period? This would appear to a loophole in the statute.
The risk, of course, is that a disgruntled buyer who wants to get out his contract might talk to a real estate lawyer who then files a lawsuit. The judge in the case may choose to look at the totality of the facts and decide that it was the intent of the parties from the beginning to enter into a long-term arrangement – i.e., longer than 180 days in the aggregate – and that the contract is therefore an executory contract. This could be a disastrous outcome for the seller given the absence of any real defenses along with the statutory penalties involved.
Will an investor be "caught" if he goes forward with a lease-purchase that utilizes a stacking technique? Maybe, maybe not. There are no "executory contract" police. Again, it all comes down to whether or not the buyer becomes dissatisfied with the deal and decides to challenge it with a lawsuit
Executory Contracts: Statutory Requirements
Make no mistake, one can still do a transaction by means of an executory contract – but many burdensome requirements now exist that did not apply before the 2005 revisions to the Property Code. Sections 5.069 and 5.070 contain a number of these requirements, which must be met before the executory contract is signed by the purchaser:
5.069(a) (1) requires that the seller provide the purchaser with a survey which is no older than a year, or a current plat.
Cancellation and Refund
5.069(a)(2) requires that the seller provide the purchaser with copies of liens, restrictive covenants, and easements affecting the property.
5.069(a)(3) requires that a "Seller´s Disclosure of Property Condition" be provided by the seller.
5.069(b) states that if the property is not located in a recorded subdivision, then the seller is required to provide a separate disclosure form stating utilities may not be available to the property until the subdivision is recorded.
5.069(c) pertains to advertising the availability of an executory contract. It requires that the advertisement disclose information regarding the availability of water, sewer, and electric service.
5.070(a)(1) requires the seller to provide the purchaser with a tax certificate from the collector for each taxing unit that collects taxes due on the property.
5.070(a)(2) requires the seller to provide the purchaser with a copy of any insurance policy, binder, or evidence that indicates the name of the insurer and insured; a description of the insured property; and the policy amount.
What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as "false, misleading, or deceptive act or practice" under the DTPA (Sec. 17.46, Texas Business & Commerce Code); secondly, the purchaser is entitled under Prop. Code Sec. 5.069(d)(2) to "cancel and rescind the executory contract and receive a full refund of all payments made to the seller." That would include any down payment plus all monthly payments that have been made to date.
Note that Prop. Code Sec. 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements have been met.
Financial Disclosure Required
An additional pre-closing requirement is imposed by Prop. Code Sec. 5.071, which requires that the seller provide a thorough RESPA-like disclosure of the financial terms of the transaction, including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a pre-payment penalty. There is some slight relief under this section in that its violation is not defined as malfeasance under the DTPA.
The 7 Day Letter
Another, related pre-closing requirement is contained in Prop. Code Sec. 5.016, which states that "A person may not convey an interest in or enter into a contract to convey an interest in residential real property that will be encumbered by a recorded lien" without giving a 7 day notice to both the lender and the purchaser. The section sets out the required content of this notice, which is quite technical. It should be observed, however, that this odd statute provides no real penalties other than to allow the purchaser to back out of the transaction prior to closing if the 7 day notice was not given. Compliance with Sec. 5.016 is therefore widely ignored with impunity. Expect the legislature to revisit this issue in future sessions.
Punitive Fees and Clauses
Sec. 5.073 prohibits these. Excessive late fees are banned, as a pre-payment penalties and any clause that "prohibits the purchaser from pledging the purchaser´s interest in the property as security to obtain a loan or place improvements. . . ."
In the past, executory contracts were not required to be recorded in the real property records. No longer. Prop. Code Sec. 5.076 states that ´the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed. Additionally, any instrument that "terminates the contract" must also be recorded.
Annual Accounting Statement
Prop. Code Sec. 5.077 requires that the seller in an executory contract provide an annual accounting statement every January, which must include the amounts paid, the remaining amount owed, the number of payments remaining, the amount paid in taxes, the amount paid for insurance, an accounting for any insurance monies paid by the insurer, and a copy of the current insurance policy.
Buyer’s Right to Convert to a Deed
The buyer has an absolute right "at any time and without paying penalties or charges of any kind" to convert an executory contract to "recorded, legal title" under Prop. Code Sec. 5.081. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract. While this right is not required to be stated in the contract, it must be available.
Buyer’s Rights upon Default
It is not permissible to simply evict a buyer under an executory contract if there is a default. Prop. Code Sections 5.063 and 5.064 specify the content of a notice of default and opportunity to cure, which must be followed to the letter if it is to be valid. In other words, the typical "3 day vacate letter" involved in evictions is not sufficient. The buyer is allowed 30 days unconditional right to cure the default.
However, if the buyer has paid in 40% or more of the purchase price, or has made the equivalent of 48 or more monthly payments, then a 60 day notice is required and, if the default is not cured, then a traditional foreclosure (not an eviction) must be used if the seller wishes to regain possession and title (Prop. Code Sec. 5.066). Sellers may take some consolation in the fact that Texas has a highly expedited non-judicial foreclosure process (41 days minimum) that can often be completed more quickly than a contested eviction.
The Reality of the Courtroom
Why not just evade the executory contract rules and continue with business as usual? The reason is that courts and juries generally do not favor investors and landlords, who are often perceived as profiteers preying upon the weak and helpless. It may not matter how clever a seller´s legal argument is. If a transaction does not pass the "smell test" a seller will likely lose. Underestimate a jury of 6 or 12 of your peers at your peril. Even if the executory contract rules are found not to apply, remember that the court can (independently of the Property Code) look to the "laundry list" of miscellaneous offenses under the DTPA. For example, DTPA Sec. 17.50(a)(3) prohibits "any unconscionable action or course of action by any person" – an exceptionally broad statement.
Forfeiture remains a hot-button area. Section 5.073(a)(4) prohibits a forfeiture of a buyer´s down payment or option fee if a monthly payment is late. This is an important change, because it codifies what judges and juries have been telling lawyers for quite some time. They hate forfeitures. The trend in the law is to view any substantial forfeiture as unreasonable and unconscionable, whether within the context of an executory contract or not, if it results in a buyer losing either a large down payment or the home itself.
Right of First Refusal (ROFR)
Is a ROFR along with a lease a way out? Yes, but caution is required.
A ROFR requires the seller, when and if he or she decides to sell, to first offer the property to the buyer. ROFR´s do not specify a price. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a limited time, to buy the property at the same price and terms. Alternatively, the price may be determined by fair market value at the time of sale. Careful: As soon as the sellers includes a specific price, it is likely that the ROFR will be transformed into an option, and one again falls within the definition of an executory contract. ROFR´s are therefore not an effective substitute for an investor seller who wants to pre-set an above-market price in order to lock in a long-term profit.
Right of First Offer (ROFO) and Right of First Negotiation (ROFN)
There are two lesser forms of preferential or pre-emptive right:
- a right of first offer (ROFO) which obligates the seller to notify a buyer of his intention to sell, and the buyer will then have the right to make an offer, the terms of which are not specified in advance; and
- a right of first negotiation (ROFN), which obligates the seller to negotiate exclusively with the buyer for a prescribed period of time. Price and terms of sale are open.
ROFR´s, ROFO´s, and ROFN´s are all potentially useful substitutes for a lease-purchase, but they must be carefully structured and worded so as not to fall into the executory conveyance trap.
Beware of Seminar Forms
Be cautious in the use of lease-option forms (or any other forms) from "guru" seminars or obtained off the internet. These forms are suspect since they may not be designed specifically for Texas. They can now get an investor in real trouble. If you have such forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I´m Doing, and the like, they are toxic waste. Throw them away. One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form. And remember, courts do not like investors. Moreover, a judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbiage – and more inclined to consider a finding of fraud.
Landlords and sellers should generally avoid lease-purchases because of the numerous requirements and potential liability for doing them improperly. Prop. Code Sec. 5.061 et seq. declares open season on the investor/seller whenever a buyer becomes disgruntled with the deal. In addition to stiff penalties contained in the Property Code, certain violations are defined to be DTPA violations which can result in treble damages plus attorney´s fees – a potential extinction event for the seller. However, one should not hesitate to utilize the "180 days or less" exemption if it suits the transaction; and, if one has a high tolerance for risk, then "stacking" might be employed
Find a good real estate lawyer, one with courtroom experience, and consult him regularly. His fees are cheap insurance. Pay attention to what he says about how a judge or jury will react to your proposed deal. A good lawyer knows that documents should be drafted as if you will one day have to defend them in court.
Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is retained and expressly retained in writing to do so.
Copyright © 2012 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com